Amazon investors need to see big bets paying off

Commentary: High valuation shows hope in margin gains at some point

Amazon CEO Jeff Bezos holds up two new models of the Kindle Fire tablet during an event in September of 2012.

SAN FRANCISCO (MarketWatch) — Are investors willing to give Amazon.com Inc. as much credit for its big investments in the future as they are giving Internet search giant Google?

It’s a crucial question to consider ahead of Amazon.com’s
AMZN, -0.89%
first-quarter report on Thursday afternoon, where expectations are clearly high. Amazon’s shares are trading more than 130 times estimated earnings for the next four quarters — about eight times the average multiple for its peer group, according to FactSet data.

And Wall Street clearly sees the stock going much higher. The current range of price targets go from a low of $245 to a high of $370 — with $320 at the median, which is more than 20% above the stock’s current level.

Many investors are hoping that the near-term pain of Amazon’s big investments in new products such as the Kindle and Kindle Fire, fulfillment centers, web services and developing its own TV shows will pay off in bigger profit margins.

Amazon CEO Jeff Bezos, though, seems to be trying to tamp down those high hopes.

“We don’t celebrate a 10% increase in the stock price like we celebrate excellent customer experience,” he wrote in his annual letter to shareholders earlier this month.

Citing the famous quote about how “In the short run, the market is a voting machine but in the long run, it is a weighing machine,” Bezos noted the stock’s recent gains of late. “We aren’t 10% smarter when that happens, and conversely aren’t 10% dumber when the stock goes the other way. We want to be weighed and we’re always working to build a heavier company.”

For the big fourth quarter of 2012, Amazon disappointed investors with revenue growth of 22%, which represented a deceleration from the third quarter. Even though that growth was far better compared with anemic or no growth at many tech stalwarts, dubbed the tech “rust belt” by the Wall Street Journal, investors focused on improved profit margins, which raised glimmers of hope that the worst of Amazon’s big-spending ways were over. Gross margins improved to 24.1% of revenue, up from 20.7%.

“We suspect more investors now believe Amazon’s margins will recover at least somewhat over the next couple of years, as the North America operating margins is now leading the way,” said Canaccord Genuity analyst Michael Graham in a note last week.

He said that while the linearity of overall margin recovery and the ultimate peak are up for debate, “we believe investors have regained comfort that it is a question of when, not if, Amazon will deliver noticeable profitability again.”

Some even believe that the company’s push to develop and build more fulfillment centers closer to customers could give Amazon an increasingly bigger mix of higher margin services.

While that’s feasible, it’s not likely to stop Bezos from pushing the company toward innovation and new development. He will find new things to spend money on. Will investors give him the same leash they now seem to be giving Google Inc.?

Google CEO Larry Page spent a great deal of time on the company’s earnings conference call last week talking about the future, including its investments in driverless cars, Google Fiber, and Google Glass, and how he gets the chills when he sees the future in things like Project Glass.

Bank of America/Merrill Lynch analyst Justin Post wrote last week that while Google’s core gross profit growth lagged revenue growth, as lower margins businesses like YouTube, Nexus, Google Play and even mobile search drive its top line, he maintains a buy on the stock. Post lowered his price target to $875 from $920, but added that some potential drivers include possibly improved mobile ad pricing and new Motorola products in the fourth quarter.

Some investors are more sanguine and just accept that both Amazon and Google will likely continue to spend on the future.

“I always enjoy reading the Bezos letter. When I read a CEO speaking to investors about having a longer term perspective, there is always the chance there could be some short-term pain (e.g. maybe investments),” said Colin Sebastian, an analyst with Robert W. Baird & Co., in an email.

“But Amazon and Google are two companies really out to change the world, and many investors are just happy to be along for the ride,” he added.

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